September 17, 2020

Investors are increasingly demanding information about what is being done with their assets and what impact their investments have on ESG aspects. In the rapidly growing market for sustainable finance, the potential is far from being exhausted. With the United Nations (UN) Sustainable Development Goals (SDGs), the Paris climate goals and the EU Commission's “Green Deal” for a climate-neutral Europe by 2050, sustainable financing is high on the priority lists of banks, asset managers and insurance companies moved.

Strategies must be aligned with the criteria for sustainability (environmental, social, governance - ESG) in a timely manner, since sustainable finance encompasses all areas of the financial industry - from customers and suitable products to the necessary realignment of internal bank strategies and processes. The entire financial system is facing a fundamental change. Banks run the risk of losing their license to operate and becoming irrelevant to customers.

Banks as drivers of transformation

Banks are faced with the challenge of responsibly accompanying economic and social change, which is being accelerated even further by the Corona crisis. You can make a significant contribution to the structural change in the real economy and to the achievement of the Paris climate targets by positioning yourself promptly in the green finance market and managing capital flows in such a way that they have a positive impact in terms of the ESG criteria.

Uniform framework conditions and standards are essential for a sustainable transformation.

All industries are affected by the recent developments, albeit to varying degrees. The banks and their critical infrastructures are also currently facing special challenges. The business model of every financial service provider includes acting with foresight, taking precautions, preparing for the worst in the interests of customers. The BaFin also sees it this way. In view of the Corona crisis, it says that it is “in close contact with banks and other financial market players about possible reactions and contingency plans” and “continuously analyzes the further development and possible effects on the financial industry”.

Financial institutions must keep an eye on internal and external factors.

Currently, numerous ESG regulations are just framework regulations that have to be specified in further legal acts.

The EU classification system (taxonomy) for green investments, the information sheet of the Federal Financial Supervisory Authority (BaFin) on dealing with sustainability risks and the regulation on sustainability-related disclosure obligations in the financial services sector are important building blocks for the successful expansion of a sustainable financial system. Instruments such as a “Green Supporting Factor” can provide additional incentives for the implementation of a sustainable financial system. The equity relief required for the granting of green loans is also linked to improvements in the use of data and methods for managing sustainability risks.

What is special about the regulations is that they will affect credit institutions as a whole. While regulation projects of the EU have so far aimed at certain areas of the banking business or banking organization (MiFID II -> securities sales, EMiR / MiFIR -> derivatives business, prospectus regulation -> issuing business; CRR / CRD -> treasury and ICS), the package of measures of the EU Action Plan has an effect on all areas of the banking value chain. This poses major challenges for the banking industry. According to current planning, the first implementation packages should come into force across the EU at the beginning of 2021.

Basis: Sustainability defined

Sustainability is a broad term. The action plan therefore provides for an EU-wide classification (taxonomy) to be created that initially focuses on ecological sustainability. The Technical Expert Group on Sustainable Finance (TEG) set up by the EU Commission presented a 400-page report in June 2019, which contains suggestions for a taxonomy methodology. The sustainability of an economic activity should thus be measurable.

In addition, the term sustainability is also of central importance in the Disclosure Regulation (Regulation (EU) 2019/2088) (published on December 9, 2019 in the EU Official Journal). This obliges financial market participants and financial advisors to be more transparent in the area of ​​sustainability. In contrast to the Taxonomy Regulation, the Disclosure Regulation is not limited to ecological sustainability, but also includes other, in particular social, aspects of sustainability.

The EU Commission wants to establish a further standard by regulating CO2 benchmarks. The currently available indices for low carbon investments have different objectives. Many of the current benchmarks aim to (merely) reduce the carbon footprint of a standard investment portfolio. However, more and more new financial products are helping to achieve the two-degree target. In order to counteract excessive growth in the member states, the EU Commission wants to create uniform standards for the methodology and transparency of CO2 benchmarks. The Benchmark Regulation (Regulation (EU) 2016/1011) was adapted accordingly by the CO2 Benchmark Regulation (Regulation (EU) 2019/2089) announced in the EU Official Journal on December 9th.

In order to further simplify sustainable investment, special labels for sustainable products are also to be introduced. An EU standard for so-called green bonds will serve as a prototype. For this purpose, the TEG presented ten recommendations and conclusions for a standard.

Vermögensanlage: Nachhaltige Produkte sollen sie prägen

Following the clarification of the question of which financial products are to be regarded as sustainable, the task is to redirect capital accordingly. The action plan stipulates that advisors and asset managers must ask their clients whether they prefer sustainable investments. If the customer answers this question in the affirmative, this must be taken into account in every investment recommendation. This approach is being implemented in regulatory terms through changes to the Level 2 regulations for MiFID II and IDD.

Risk management: Sustainability risks must be taken into account

The action plan calls for the risk management of credit institutions, insurance companies, capital management companies and rating agencies to take into account all risks arising from climate change, scarcity of resources, environmental degradation and social problems (overall ESG risks). The inclusion of considerations on sustainable finance is therefore also gaining momentum in banking supervisory law:

• On December 6, 2019, the EBA presented an action plan for sustainable financing, which contains the EBA's program of measures for the coming years up to 2025.
• On December 20, 2019, BaFin published its information sheet on dealing with sustainability risks. In the opinion of BaFin, a "top down" approach is required within the company - i.e. from the board of directors to the departments - and therefore a strategic approach by the management to sustainability risks within the business and risk strategy. The institutions should develop an understanding of significant sustainability risks as well as their possible effects on their own business.

The BaFin information sheet initially only formulates “soft” requirements that are only intended to serve as a guide when including sustainability risks in the risk assessment. It is foreseeable, however, that the recommendations of the BaFin information sheet will be incorporated into the ongoing European regulatory process.

Transparency: Issues of sustainability should be transparent in company reports

The EU Commission also wants to promote transparency about sustainability in corporate reporting and management. To this end, EU guidelines on climate-related reporting in the context of reporting on non-financial information have been published. According to this, a company should provide information about climate-related opportunities and risks that can influence its business model. The guidelines are so far non-binding and do not create any legal obligations.

However, the final compromise to the Taxonomy Regulation provides for binding disclosure requirements for certain companies. In addition, the EU Commission wants to investigate whether there is inadequate pressure on companies from the capital market to concentrate on short-term returns and neglect sustainability factors. On December 18, 2019, the EBA, ESMA and EIOPA submitted reports on this that contain a number of suggestions for improvement and advise further monitoring.

Outlook: The pace is increasing

The EU Commission has initiated a large number of (regulatory) projects in order to achieve the goal of sustainable growth. The ECB and national central banks are already thinking about how they can use their funds to further promote sustainability. The Network for Greening the Financial System (NFGS), to which central banks and supervisory authorities have belonged since 2017, recently published an initial report on recommendations for action for supervisory authorities.

The Sustainable Finance Advisory Board has been created at the national level to advise the Federal Government on developing a corresponding strategy. Against the background of rapidly advancing global warming, this process appears politically irreversible.

Conclusion: Sustainable finance must be viewed holistically!

In view of the comprehensive regulatory approach of the EU, banks will no longer be able to deal with the topic of “sustainable finance” in individual silos. We strongly advise you to take a holistic view of all opportunities and risks for your own business model. This is the only way to create the necessary interfaces between the individual business areas and the controlling functions (risk, compliance, revision). Banks can even strengthen their competitiveness by positioning themselves early on in the rapidly growing market for sustainable finance and consistently aligning their business models with the criteria for sustainability. The consultants from Bersch Consulting are at your side with both regulatory adjustments and the realignment towards a sustainable company.